Published in briefings, issue 1, 2004
The talk may be about slowdown, but the deal-making pace in China remains frenetic. According to data compiled by M&A Asia and recently released by PricewaterhouseCoopers in Hong Kong, in the first three months of this calendar year (2004) the value of M&A deals in China was $12.3 billion, representing a jump of no less than 55 per cent compared with the comparable period in 2003.
Notwithstanding recent interest rate concerns, PwC estimates that aggregate deal values for 2004 overall will still be up 30 to 40 per cent over 2003. Jim Woods, PwC Transaction Services partner in Hong Kong, says a “solid and sustained” overall recovery in deal-making has followed a mid-2003 slow-down that was largely attributable to the impact of SARS. And he expects “considerably stronger” M&A figures for 2004 overall, compared with the previous year.
Amid all the activity, Woods has also noted increased investment interest this year from Australian private equity funds. Commercial relationships between China and Australia are developing rapidly, too.
The importance of China’s place in Australia’s future is hard to exaggerate. China is now Australia’s second biggest export customer after Japan. And an Australia-China Trade and Economic Framework signed last year commits both governments to a detailed joint study of the feasibility and benefits of a free trade agreement between the two countries. The study, to be completed by October 2005, covers a range of activities including not only energy, mining and agriculture, but also textiles, clothing and footwear, services, investment, education and intellectual capital transfer.
Ken DeWoskin, who has been involved in economic and business development in China and Japan for 40 years as a PwC partner and now consulting with PwC, says: "There is so much Chinese manufacturing capacity developing, that in the next decade the value of commodity resources consumed in the manufacturing will continue to grow relative to the value of the goods manufactured. Australia’s position in that value chain is very enviable because its strengths are so complementary to China’s.”
Highlighting the potential of the China-Australia relationship have been such heavyweight resources deals as this year’s BHP Billiton $13 billion iron ore contract. The BHP Billiton agreement to supply Chinese steel mills with about 12 million tonnes of iron ore every year for the next 25 years followed an earlier $25 billion natural gas supply contract won by the Australian Liquefied Natural Gas consortium.
And then there’s the Olympics. Companies associated with the success of the Sydney 2000 Olympic Games are marketing a vast array of products and services to China in the lead up to Beijing’s 2008 games. Major companies winning Olympic business include Telstra and Macquarie Bank, which is advising on finance for the Olympic stadium.
Small providers are heavily involved. Australian companies have won about half of the design competitions so far, including those for the aquatic park, the shooting range, and the Olympic Green. A Sydney Beijing Olympic Secretariat that was set up in 2002 is likely to open up further opportunities.
International markets
For manufacturers around the world, the need to slash production costs to stay competitive in external markets has been a compelling China drawcard. The same companies have more recently been building factories in China to supply the booming local as well as international markets - and doing well. Martyn Mitchell, PwC lead advisory partner in Australia for business with China, says: “Three years ago we would have been talking to executives about how they can cut their losses and get out of China. Now we’re talking to people who are beginning to make money and want to repatriate their profits. It shows how the market has come of age.”
Shanghai-based Spencer Chong, PwC China transfer pricing leader, remarks that historically, foreign investors have been most interested in businesses which are located in popular cities such as Beijing and Shanghai. “But increasingly,” he says, “we are seeing this interest spread to other regions in mainland China, such as the western provinces. We believe that this trend is likely to continue.”
But the risks remain significant. As Martyn Mitchell notes, some of the world’s biggest companies have seen their ambitions in China flounder. Many Australian companies that invested years ago have cut their losses and sold assets at well below cost. Others have turned a profit only after many years of trial and error. Many are still to turn a profit.
Macquarie Bank is one major Australian corporate that has been successfully involved in China for some years. Macquarie first set up Chinese offices in the mid-1990s - in Tianjin in 1995 and Shanghai in 1996 - to service the property and mortgage sectors. In March 2002, it established a home loan brokerage business in Shanghai and this year opens an office in Beijing to provide investment banking services, with a particular focus on the resources and infrastructure industries.
But Warwick Smith, an executive director of Macquarie and also now national president of the Australia China Business Council, observes that China’s entry to the World Trade Organisation has brought additional complexities in the form of a raft of policy and legal changes. Smith, who first visited the country in 1986, advises: “Any company considering doing business in China needs to research very carefully and, as with any new market, proceed with caution.”
Graeme Billings, PwC industrial products leader in Australia, comments that a strong $A made it natural for Australian companies to focus on alternative sourcing options in low-cost countries. “Under certain capital management criteria,” he says, “China becomes a viable manufacturing option, with Australian operations concentrating on adding value in brand management and the improvement of logistics and distribution channels.” But he adds that “it’s important to carefully differentiate between a strategic path and decisions that are just reactive or tactical.”
War stories
Given the numerous sad “war stories” of over-hasty business commitments in China, Martyn Mitchell is struck by the strength of the current drive among smaller Australian companies to enter the Chinese market: “We’re finding that a large number of smaller companies that have never been offshore want China to be their first move,” he says.
“These are companies that haven’t even tried their arm in a relatively congenial nearby market such as New Zealand. Instead they seem to think a presence in China is a licence to make money. Well, if you don’t do your due diligence it’s just a licence to burn money.”
DeWoskin agrees. “You’re always dealing with a very unusual mix of regulators, the State as business owner, and then commercial entrepreneurs in often hard-to-fathom relationships with the State. It all makes China a bit difficult to understand,” he says.
None of the cautionary tales however belie the scale of the opportunity that China can still provide foreign companies, provided they have done their homework - and know how to manage risk.
Slow is better...
BlueScope Steel, formerly BHP steel, is an outstanding example of an Australian company that’s successfully carried through a major commitment to China as part of a larger Asian growth strategy. The company’s success provides a useful study for other companies - especially those that may be tempted to do too much too soon in China.
Earlier this year, BlueScope approved construction of the latest in a series of Chinese investments going back several years: a $280 million facility in Suzhou Industrial Park in the Jiangsu province, 80 kilometres west of Shanghai.
The company’s rationale for such major commitments in China - and elsewhere in Asia - is straightforward: China, and the ASEAN nations, are experiencing the world’s most attractive growth rates in building and construction markets. Chinese steel consumption is expected to increase this year by more than 12 per cent to over 250 million tonnes, representing a staggering 27 per cent of global steel production.
CFO Brian Kruger says: “We have built a strong position at the high quality, premium end of the Chinese market and have been successful in a number of landmark building projects, including the new Beijing international airport.”
The interesting key to this success however has been the very careful pacing of the company’s investment build-up. As in other parts of Asia, this has been based on the concept of ‘backward integration’.
BlueScope’s initial investments in China were relatively small-scale roll-forming plants - in Shanghai in 1995, followed by Guangzhou in 1996 and Langfang and Chengdu in 2003 - involving establishment costs of $5-10 million each.
These were in addition to a gradual build-up of roll-forming facilities elsewhere in the region: in Thailand, Malaysia and Indonesia, as well as in Taiwan, Singapore, Brunei, Sri Lanka, Fiji, New Caledonia and Vanuatu. (In total, BlueScope’s Lysaght roll-forming business now operates at 24 sites across 12 countries in Asia and the Pacific Islands.)
But while the initial investments in China were relatively modest, the accompanying market development activities were significant, with sales efforts supported by 47 offices throughout the country.
Brian Kruger says: “Our strategy is that as markets for our high quality products develop to the point where larger-scale investment is warranted, we look to ‘backward integrate’ with our coating and painting line capacity established not only in China but also in Thailand, Malaysia and Indonesia with a further factory now also underway in Vietnam.
As Kruger says, “This gradual, incremental approach to investment has contributed to effectively managing risk.”
...And watch the structure
The scope of BlueScope’s activities throughout the Asia-Pacific region also points to the general need for companies to carefully consider company structure. Lyndon James, PwC lead taxation services partner in Australia for business in China, observes that in an environment in which trade within Asia is expanding faster than Asia’s trade with the rest of the world, Australian companies will increasingly be operating as regional multinationals, probably with China as the low-cost centre of manufacturing using inputs from the region.
To illustrate the point, PwC develops model multinational structures showing how companies may take advantage of varying tax rates.
Optimised model for regional companies
 
The China challenge: here to stay
In mid-2004, as efforts by the Chinese authorities to restrain the tearaway pace of growth gained traction, some economic slowdown was evident in the official statistics. Industrial output reportedly slowed in May from the 19.1 per cent figure recorded for April to 17.5 per cent - a rate of growth that might still fairly be described as brisk, to put it mildly. And while the growth of fixed asset investment declined from a staggering 43 per cent growth rate in the first four months of the year, in May it was still running at an annual rate of 18.3 per cent.
Whatever the immediate future, the economic transformation that has occurred since the beginnings of liberalisation in the late 1970s is historically unprecedented. The movement from the countryside of some 300 million of China’s 1.3 billion people has generated not only new cities but a whole series of mind-boggling statistics.
China last year absorbed approximately two-fifths of the world’s cement output; one-third of its iron ore, steel and coal; one-fifth of its alumina and aluminium; and one quarter of its copper. China is also now the world’s biggest importer of tin, zinc, rubber, fabrics and foods.
Last year 1.8 million cars were sold in China, bringing the total to more than 10 million. Partly as a result, the country has now overtaken Japan as the world’s second largest importer of oil (after the US), last year buying 8 per cent of global oil supplies.
China’s massive environmental problems are no less mind-boggling. It is reported that more than 700,000 people die each year in China from indoor pollution caused by coal-burning. In about two-thirds of China’s cities, the air quality fails to meet the country’s own national air-quality levels. And more than 700 million Chinese people have to drink water contaminated by human and animal waste.
But the capacity to overcome such problems is itself the product of the modernisation that is now underway. It is expected that by 2030, a further 400 million Chinese will have moved from the countryside to the cities. For business in Australia, as elsewhere in the world, the China challenge is here to stay.
For further information contact PwC partner Martyn Mitchell
martyn.mitchell@au.pwc.com
Tel: + 61 2 8266 7645
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